Taking the P? Sending up ‘Price’ in Fund Selection
Taking the P is a guest post for Investment Quorum and will appeal to those particularly keen and informed upon investment matters.
Like Supersonic flight, the beginnings of fund selection can be traced back about 70 years. At the Association of Professional Fund Investors (APFI) we aim to represent the views of Professional Fund Investors (‘PFIs’), innovate and recognise best practice. Professional fund investing and research is a community, one I have been proudly part of for a little under two decades. However that pride has faced many tough lessons and challenges over the years. Today, as the industry digests the 200 pages that make up the FCA Interim Market Study Report (MS15/2.2, https://www.fca.org.uk/publication/market-studies/ms15-2-2-interim-report.pdf), questions as to the effectiveness of investment consulting; selecting active managers and negotiating costs have arisen.
Buried deep in its report, in chapter 8 (from page 180), the FCA critiques the Multi-P (‘X-P’) approach used by many fund rating agencies and investment consultants. Why do fund buyers, consultants and agencies use a X-P approach and how does embedding Price into that process impact the findings of the FCA?
Origins of the X-P Consultant Model
The X-P model began in the 1940s with 4-P: Product, Price, Promotion and Place.
According to Wiki (the de facto font of all information and disinformation) the origins of the four Ps can be traced back to Professor of Marketing at Harvard University, Prof. James Culliton. In 1948, Culliton published a paper ‘The Management of Marketing Costs’. Culliton described marketers as ‘mixers of ingredients’. Some years later, Culliton’s colleague, Professor Neil Borden, published a retrospective article and credited himself as popularising the concept including his presidential address to the American Marketing Association in 1953. The 4-Ps, in today’s form, was first proposed in 1960 by E. Jerome McCarthy in his text-book, ‘Basic Marketing: A Managerial Approach’. McCarthy used the 4-Ps as a framework for the entire work with chapters devoted to each of the elements, dedicated to analysis, consumer behaviour, marketing research, market segmentation and planning to round out the managerial approach. Author Phillip Kotler likewise popularised the approach and, and with it, spread the concept of the 4-Ps.
As a generation of Regan and Thatcherite Ivy graduates, entered consultancy, the rapid adoption of 4-Ps accelerated through the 1980s, and the phenomenon of the ‘business consultant’ took hold. This popularised the concept into commerce and any new consultant or business at that time was expected to demonstrate awareness of latest management techniques.
In 1981, Booms and Bitner proposed a model of 7-Ps, comprising the original 4-Ps plus process, people and physical evidence. Subsequently a number of different proposals for a service marketing mix (ranging 6-Ps, 7-Ps, 8-Ps, 9-Ps and more) have emerged through leading big management consultancies like McKinsey. Launching into this environment it comes as no surprise that the early progenitors of multi-manager and asset consultancy adopted a common language with, management consultants, whether that was the optimal approach or not.
The History of Consultants and Ratings Agencies
The rise of asset consultancies post ‘Big Bang’ in October 1986 and and the previous Employee Retirement Income Security Act ‘ERISA’ (1974 in US) led to the slow Americanisation and gradual de-institutionalisation of the UK asset management market. An influx of not only large US banks but also consultants coincided with the gradual demise of U.K. insurance With Profits and Defined Benefit schemes. In the FCA report a shadow has been cast on the dominance of the big consultants, which now have a grip on many facets of our industry. Given the power of investment consultants, as gatekeepers, then the FCA was right it its report to question whether this not only impacts the returns for their clients but also impacts the wider market for the rest of us.
“The point missing from these considerations is any strong emphasis on investment consultants’ performance. This may be because, as we found, there is limited information available to institutional investors on the quality or performance of advice when they are selecting a consultant.”
Big consultants include;
Russell Investments was founded in 1936, employs 1700 employees and manages $244bn assets under management, opening its first office in London in 1979, launching its multi-manager service in 1980 and launching the now famous Russell indices in 1984. Russell has become synonymous with equity style and capitalisation investing and for building one of the first X-P models, which it has since evolved. Russell is credited for introducing the X-P model into fund research. Russell is generally regarded as one of the most thorough multi-managers, at least from the point of view of conducting due diligence on a fund manager.
Owned by Marsh & McLennan, Mercers was founded in 1945, headquartered in New York, employs over 20,000 employees in 40 countries, and serving over 130 countries. Originally called William M. Mercer after the Canadian firm was acquired by Marsh & McLennan. The history of Mercers has been one of acquisition. Mercers moved into DC investment consulting in the U.K. around 2005, starting with 60 different funds managed by over 20 investment managers. In 2012 Mercers moved into investment management in the U.K. Mercers global team numbers 1,200 professionals and 120 manager researchers provides in-depth expertise in research, advice, and solutions. Mercers assert their advantage based around their Global Investment Manager Database (‘GIMD’) which uses data capture, analyst inputs and big data to support more conventional fund research.
Aon Hewitt was founded in 1940 in Illinois, as Hewitt Associates, has approximately 29,000 employees worldwide, operating in 500 offices in 120 countries. By the beginning of the 1990s Hewitt had ventured abroad and offered benefit programs to corporations in the United Kingdom. By 1997 more than 100 large companies outsourced their benefit programs to Hewitt, covering about nine million worldwide employees.
Morningstar influences/manages over $200bn assets under management in 27 different countries and and is the quoted largest fund ratings platform with around 180 fund analysts worldwide. Launching into the UK with its innocuous website service the business has grown exponentially through its fund analysis and reporting software ‘Direct’ and asset tool ‘Encore’. Morningstar, Inc. has been providing qualitative analyst research on funds since the 1980s. Morningstar has been one of the leading X-P rating agencies, which is a 6 factor approach (originally 5-P) that includes Price. It remains easily the largest agency in the UK retail market but also competes in the Institutional market. It is worth recognising that Morningstar’s model differs to that of investment consultancies albeit does supply consultancy and investment management, thus blurring lines.
Others include JLT, Willis Towers Watson, Capita, Hymans Robertson, Fitch, Punter Southall.
The Impact of Embedding Price into X-P Selection
The FCA, in its report, identified the typical X-P model as; embedding Price into an overall fund rating. I have traditionally approached investment selection and fees separately. I developed a 6-P model but did not embed Price. We did consider but chose against, why? Colleagues have mistakingly misconstrued this to mean that I don’t look at costs. Actually quite the opposite is true and today I can (and do) spend more time on negotiating and monitoring fees, as conducting due diligence on the fund.
Price and the other P-factors are not exclusive from each other but, by setting fee hurdles separately, I will not inadvertently buy into funds at any cost (no matter how good I think the manager is). I call this avoiding the ‘value proposition trap’. It means I am left agnostic and bi-partisan between active and index-based funds; on cost at least, albeit I admit to some active bias in terms of my investment philosophy. Conversely many consultants and agencies capture the concept of ‘value for money’ as Price in their multi factor (X-P) model. The danger of doing this is it can create remoteness and aggregates the outcome, it can lead to selection falling into that trap. This can be both mitigated by or compounded by committee structures, which prevail in the larger firms. The FCA report reported median fees that would indicate that large consultancies have confused cost with value. Aggregating Price as a P-factor may have thus missed a point. Let’s take a simple working example;
Fig. Consultant rating – aggregating Price into a X-P rating.
|Fund Manager A||Type||Weighting||Score (0-100)|
|People||Qualitative||20%||80 (16) = Strong/Green|
|Process||Qualitative||20%||70 (14) = Good/Green|
|Portfolio||Qualitative||20%||60 (12) = Fair/Amber|
|Performance||Quantitative||20%||60 (12) = Fair/Amber|
|Price||Quantitative||20%||40 (8) = Poor/Red|
|Total||Blended||100%||72/100 = Good/Green|
Let’s assume that a fund below a score of 50 = Red (SELL), up to 70 = Amber (HOLD), above 70 = Green (Good/BUY) or above 80 = Green (Strong/BUY). In effect the consultant rates the fund manager based on a combination of tangible and intangible factors. By scoring the manager highly on qualitative P factors (People, Process, Portfolio) they can override the poor rating on Price and average rating on Performance. Here aggregation obfuscates the impact of Price on the fund rating. The danger for larger consultants and research firms is not seeing the wood from the trees. This can be exacerbated by a remoteness to end investors and trustees’ inability to monitor consultants effectively due to an information disadvantage and lack of investment expertise generally on boards (but a low propensity to admit this). Also the analyst is often unable to modify the ratings doctrine or override hierarchical decisions by committees.
Before we can consider the behavioural biases like anchoring, confirmation bias and star manager culture; many consultants are more simply incentivised to put more time into the client relationship and communication than the belying research. When they do engage in research then there is also a danger of putting funds under an increasing microscope in some areas but failing to step back to get the basics right like Price. Only after addressing this can a balanced assessment of employing active and index funds be achieved.
Here then (at least based on the inference of the FCA paper) big consultants can become very skilled at convincing clients into mediocre choices. This is compounded by a lack of retrospective on the outcomes they produce, until now. Indeed the FCA noted;
“Overall, we found that there is not a strong emphasis on fees in the consultants’ rating process. For example, one consultant explained that fees only made up 5% of the final score. When discussing the rating process, only one consultant acknowledged upfront that in some asset classes actively managed funds do not, after fees and in aggregate, add value for investors and keeping costs to a minimum is important to increasing their clients’ chances of outperforming the index.”
In January 2016 legend Chuck Yeager celebrated the 70th anniversary of pioneering supersonic flight in the X-1 jet (1946). Like flight, innovation is much needed in Fund Selection. The issues facing investment consulting can be addressed by examining the capability and motivations of investment consultants and fund rating agencies, and challenging the efficacy of quantitative and qualitative aspects of the X-P model. Taking a fresh look at Price in context to fund ratings is necessary, one solution may be separation.
This may also create an opportunity for innovative smaller firms and agencies, as pension schemes are rightly encouraged to re-think and look further afield to find value, rather than use the same small group of big consultants. More governance is needed and broader best practice needs to be shared including but not limited to the big consultants. However unlike the sweeping assumption by the FCA, the automatic answer does not necessarily have to be ‘more passive’. By joining the Association of Professional Fund Investors you can join others in exploring this issue further. Take off!
Go to profundinvestors.com
Jon ‘JB’ Beckett, Chartered MCSI
JB has been a fund selector for over 16 years, is a FTSE100 Professional Fund Investor, UK Lead for the Association of Professional Fund Investors, Author and Senior Reviewer for the Chartered Institute for Securities and Investments (CISI.org) and Author of ‘#NewFundOrder’. jbbeckett.simpl.com
Taking the P? Sending up ‘Price’ in Fund Selection is a guest post and the views here do not necessarily concur with those of Investment Quorum. In fact, it is very often the case that we may be largely in disagreement but we respect the opinions of others and value their contribution to the wealth management debate. Guest posts may appeal more to some than others and may often have an industry, stock market or sector knowledge expectation.
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